Dear valued clients,
We hope you are doing well. Week four of the Covid-19 shutdown is in the books and we expect it to continue for the foreseeable future. However, there is a silver lining to this whole situation and it’s not just about buying stocks at a discount! Many people are using this period as an opportunity to hit the reset button by spending more time with their families and taking a step back from the hustle and bustle of our day-to-day lives. It’s easy to overlook, but it’s something we all need from time to time. As we enter the holiday weekend, keep these thoughts in mind. It will help you stay focused on the positive things in life.
As for the spread of the virus, it appears that we may be approaching a tipping point. The number of new cases at home and abroad grew substantially over the past week, although we are beginning to see some signs of a slowdown. It was initially thought that the first two weeks of April would be the most painful phase of the pandemic. The consensus among experts suggested that the growth rate in new cases and number of deaths would hit its apex during this time. While it’s been a very difficult time for many people, it turns out that the severity of both measures is not as bad as expected. This has led the government to update their models and reduce their projections for the overall number of infections and deaths. It feels good to see some positive developments, but we are still in the eye of the hurricane. As such, it’s important to continue taking the advice of our medical professionals.
So, from an investment perspective where does this put us? The markets have continued to show strong signals of stabilization. The S&P is up roughly 11% over the past week, and the VIX, a well-known fear gauge for the markets, has fallen to its lowest level since March 6. At this point, it’s clear the market has fully priced in the severe pull-back of economic activity that we will encounter this year. What’s not clear is if the market has accounted for the second-order effects of the virus. The deterioration of small businesses, high levels of unemployment, and the strain on our healthcare system all have the potential to create a domino effect of unanticipated consequences. This could cause the S&P to take a second leg lower and retest the low we made on March 23. Or these concerns could fade out, which would keep the market chugging higher. We’re not fortune tellers, so we can’t tell you precisely what will happen. What we do know is that given the high degree of uncertainty, it’s vital that we stick to our investment process. When we discuss the equity markets, you’ll often find that we refer to our stock selection process. We like to buy high quality businesses when they’re trading at a significant discount. This is a valuable tool for us, but its important to note that this is primarily used to enhance the return of portfolios. When it comes to constructing a portfolio that can survive through the vicious ups and downs of markets, we take a broader approach.
Our investment process starts by utilizing a well-known conventional approach, known as asset allocation. This refers to the split between stocks and bonds. The stocks are used for growth, while the bonds are used to generate income and provide stability. This is the first layer of the cake. When you head down to the second, we implement the same methodology on a more granular level for our specific stock and bond investments. For the purposes of this discussion, we will focus on the stocks. Based on established research and observations, evidence shows that allocating to a globally diversified equity portfolio offers improved risk-adjusted returns over the long term. In more simplistic terms, this means investing in stock markets at home and overseas has proven to provide a more stable stream of returns. This is due to the diversification benefit that comes from not solely relying on the economic growth produced by one single region, and the ability to benefit from profitable investment opportunities in various countries. Provided below is a chart produced by Vanguard and FactSet which visually displays this concept. The green line represents the one-year relative return of U.S. stocks vs. international stocks. When the green line is positive (above the black horizontal line in the middle), it means U.S. stocks outperformed international stocks over the prior year. On the reverse, its negative when international stocks outperform U.S. stocks. The relative returns appear to move in a somewhat random fashion, albeit there have been some noticeably long periods of outperformance on both sides. Circled in blue are long periods of outperformance from U.S. stocks, and circled in red are long periods of outperformance from international stocks. To be more precise with the dates, U.S. stocks outperformed for the majority of the 1990’s, as well as the bulk of this past decade. International stocks outperformed for the entire mid-late 1980’s and the majority of the 2000’s. If we invested in both over the prior 40 years, we would have smoothed out our returns when compared to investing in one vs the other. From a financial planning perspective, this is an important factor as investors approach and enter retirement.
Why Own International Stocks?
Clearly, U.S. stocks have been the place to be over the past decade, but as we’ve shown that is not always the case. It’s important to keep this fact in mind because investors are susceptible to a tendency known as the recency bias, where they base their forward-looking expectations on recently reported data. If the recent past indicated the path of the future, then yes, we could throw all this out and allocate 100% to U.S. stocks. However, this just isn’t the case. As professional investors, we are cognizant of this behavioral bias and take the necessary steps to avoid it. We do this by following a rules-based, passively managed approach to our regional equity allocation. This is done through our process of consistently allocating 75% of our equity investments to U.S. stocks and 25% to international stocks.
By simply observing the historical data, one could make an argument that the trend of U.S. outperformance is due for a shift sometime soon. In addition, several valuation ratios are signaling that international stocks offer more upside relative to U.S. stocks. While we stay up to date and informed on these changing dynamics, we do not use them as a basis for decision making. A shift may occur, or it may not. Regardless, we simply don’t play that game as it’s not our core competency.
Our primary expertise lies in our ability to identify high quality U.S.-based businesses, with sustainable competitive advantages that are trading at a significant discount to their underlying value. Throughout this downturn, multiple opportunities have presented themselves and we have taken full advantage of them. Going forward, it is unclear how many more opportunities we’ll see. Our window may have closed, or it may creak back open if the virus or economic downturn gets worse than expected. Nevertheless, we have a sound plan in place and will continue to monitor for further developments. As always, please reach out with any questions or concerns. We’re here to serve.